As "fiscal cliff" nears, market complacency sets in

Angela Moon, Steven C. Johnson

6 Min Read

U.S. Treasury Secretary Tim Geithner gestures as he is interviewed by Bob Schieffer (not pictured) in Washington, on November 30, 2012 for the December 2, 2012 edition of "Face the Nation" in this CBS handout. REUTERS/Chris Usher/CBS News/Handout

NEW YORK (Reuters) - Like many on Wall Street, investor Todd Petzel cringed when U.S. Treasury Secretary Timothy Geithner said this past Wednesday that he was ready to let the economy go over the “fiscal cliff” if Republicans would not agree to higher tax rates on the rich.

“I didn’t think good things would come out of the comment,” said Petzel, the chief investment officer at Offit Capital Advisors in New York. “But nothing happened.”

The rhetoric heated up again on Friday, when Republican House Speaker John Boehner accused President Barack Obama of “slow-walking” the economy to the edge of the cliff. Again, markets brushed it off and showed very little reaction.

Investors’ collective shrug marks a stark change from how they had behaved in the two weeks after the presidential election, when nearly every utterance from a politician about the looming budget crisis caused wild swings in stock prices.

The S&P 500 index has nearly retraced the 5.3 percent slide it suffered in the first seven sessions after the November 6 vote. Some of the rebound reflects market confidence that Democrats and Republicans, despite their rhetoric, will eventually agree on at least a short-term deal to avoid the cliff - nearly $600 billion of tax increases and spending cuts set to take effect in January that could bring on a new recession.

It also could be that investors have peered over the cliff and realized they are looking at a gentle slope instead.

“The sentiment has definitely changed,” said Andrew Wilkinson, chief economic strategist at Miller Tabak & Co in New York. “The market has become somewhat desensitized to headlines out of Washington because the fear of the economy hitting a wall in 2013 if we don’t get a deal done has diminished.”

While the S&P 500 was on track to end the first week of December nearly flat, performance throughout November was far more volatile, with the index lurching from a loss of more than 2 percent one week to a gain of more than 3 percent the next. The benchmark ended the month 0.3 percent higher.

“Seasoned investors know that waiting on the sidelines for clarity about fiscal negotiations is not an option,” Carmine Grigoli, chief investment strategist at Mizuho Securities, wrote this week in a note to clients.

“In our view, the worst case outcomes are likely to be avoided and the stock market should rise by 5 percent to 7 percent once the risk of fiscal Armageddon is behind us.”

SENTIMENT HAS CHANGED

Not everyone is brushing off the risks entirely. Investors could be too sanguine and the end of the year could come without a deal. The market could yet lurch downward, repeating the big sell-offs that occurred during the 2011 debt ceiling talks.

But while chief executives have complained that not knowing what future taxes will be has suppressed investment and hiring, some investors say lawmakers still have time in early 2013 to strike a deficit-reduction deal without imperiling the economy.

Michael Fredericks, lead manager of the BlackRock Multi-Asset Income Fund, said the recent malaise may simply be “a little bit of fatigue” setting in.

“This short-termism and parsing the language that comes out of the mouths of politicians is getting a little old. People are stepping back and saying: ‘How can I possibly make an investment decision based on the next press release or TV appearance by the latest senior Republican or Democrat?'”

One indicator of the market’s reduced concern is the defense sector, which will be hit hard if the spending cuts take effect. The PHLX Defense Sector Index is up 13 percent for the year, and sits just a few points from a yearly high.

The CBOE Volatility index, Wall Street’s so-called fear gauge that tends to move inversely to the S&P 500, has slipped about 2 percent since November 1.

“Lately, we’ve just started seeing some small upticks in VIX futures. But it’s not like someone is coming into the market to buy a whole lot. It’s just nibbling here and there, which shows that there isn’t too much concern out there about the fiscal cliff,” said J.J. Kinahan, chief derivatives strategist at the brokerage TD Ameritrade in Chicago.

A survey of 62 Wall Street money managers released on December 5 showed market losses would be manageable if the U.S. goes over the fiscal cliff, even though worries still run deep.

Conducted by the Washington-based Potomac Research Group, the survey showed more than 60 percent expected the Dow Jones industrial average to fall 10 percent or more if a deal is not reached by year end. That would put the blue chip index below the 12,000 level.

Petzel called that 10 percent estimate “plausible,” adding that the market’s newfound calm about the cliff was more to do with the “numbness that comes from watching every moment of a blow-by-blow negotiation” than with a lack of concern.

The good news is that such a sharp drop likely will convince Republicans and Democrats to find common ground. That, he said, is what happened in the past few years to European policymakers, who saw markets sell off when they were slow to address an ongoing debt crisis.

“Then they realize, ‘Oh, this is a big deal, we should get it right.’ And so they would do something - not a lot - but something that the market could hang its hat on, and that would spark a rebound.”